Cash Flow Real Estate

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					                Chapter 14
             Cash Flow Analysis




12/13/2005     FIN4777 - Special Topics in Real Estate - Professor Rui Yao   1




                       Introduction
♦ Cash flow drives values for income property
♦ Current and future returns are a based upon
  cash flow estimates
♦ Appreciation is driven by increases in the
  cash flow
♦ Development, acquisition, leasing,
  marketing and management decisions are
  all driven by or intended to influence cash
  flows



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                                                                                 1
                 Developing a Pro forma
♦ The Pro forma is an accounting style
     projection of operating statement over time
     ♦ It is a forecast of the future
     ♦ Typically on an annual projection basis
     ♦ Start with the initial operation of the property after
             the development and lease phase
     ♦ Alternatively, begin after acquisition of an
             existing property and run through the anticipated
             sale
♦ Provides the information that drives
     investment, financing and management
     decisions

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             Steps to Develop a Pro forma
Step 1. Estimate Gross Rent
Step 2. Subtract Estimated Vacancy
Step 3. Add other income
     = EGI (Effective Gross Income)
Step 4. Subtract Operating Expenses
     = NOI (Net Operating Income)
Step 5. Subtract Debt Service
  = BTCF (Before Taxes Cash Flow)




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                                                                                        2
             Steps to Develop a Pro forma
                                 (Contd.)
Step 6. Add the Mortgage Principal Repaid to
        BTCF
Step 7. Subtract Depreciation
Step 8. Subtract the Amortization Points,
        Leasing Commissions, and
        TI (tenant improvements)
     = Taxable Income
Step 9. BTCF - Taxes
     = ATCF (After Tax Cash Flow)


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                 “Proforma” (Contd.)
1. Potential Gross Rent
♦ Potential Gross rent is the rent that might be
  collected on a property if it is 100% occupied
  (Maximum Rent)
♦ Projections of gross rent should consider:
         Existing leases
         Market rents on peer properties
         Projected supply and demand
♦ In a stable market rents might be expected to grow at
  the expected rate of inflation


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                                                                                     3
               “Proforma” (Contd.)
2. Estimated Vacancy
♦ Vacancy results from:
         Normal mobility of tenants
         Need to retrofit units for new tenants
         Over-supply of similar property
♦ Estimate of forward vacancy rates should consider:
         Local peer group property vacancy rates
         Existing tenant leases




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                   “Proforma” (Contd.)

3. Other Income
♦ Other sources of income:
         Laundry vending
         Parking
         Percentage rents on retail leases
         Cable or network access
         Other additional services




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                                                                                     4
                “Proforma” (Contd.)
4. Operating Expenses
 ♦ Based on historical information and industry
   benchmarks (provided by trade associations)
 ♦ Estimated using simple per SF figures or through a
   detailed analysis of all the potential operating
   expense accounts:
        Management expense                            Utilities not charged to
        Leasing commissions                          tenants
        Tenant improvements                           Exterminators
        Property insurance                            Advertisements
        Property taxes                                Roof repair
        Cleaning/Security                             Maintenance
        Landscaping                                   Supplies

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                     “Proforma” (Contd.)
5. Debt Service
♦ Debt service is the sum of all mortgage payments
  required for the year including principal loan
  repayment as well as interest payments
♦ Mortgage payment is an annuity
     Input:
        PV- Projected mortgage loan
        N - Number of periods
        I - Interest rate per period
     Solve for “PMT” i.e. payment
     Multiply PMT by 12 to get debt service




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                                                                                      5
                   “Proforma” (Contd.)
6. Mortgage Principal Repaid to BTCF
♦ The mortgage principal repaid is the portion of the
  debt service that exceeded the interest due
♦ The loan balance is reduced each month
♦ The sum of the principal loan repaid for one year is
  the adjustment needed here


    Alternative Approach:
♦ Start with NOI and deduct mortgage interest




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                   “Proforma” (Contd.)
 7. Depreciation
 ♦ Non cash expense permitted by IRS as a deduction
   from income in calculation of taxable income
 ♦ Steps to calculate depreciation:
             Deduct the land value from property value (as
             land cannot be depreciated)
             Divide this number by total economic life of the
             property (27.5 for residential and 39 for
             commercial, as per 2001 tax laws)
             This is the straight line depreciation value



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                                                                                         6
                “Proforma” (Contd.)
8. Amortization of Points, Leasing Commissions
and Tenant Improvement
♦ Points is prepaid mortgage interest, paid at time of
  the loan origination
♦ Points are amortized in level fashion over the term of
  the loan until the end of loan term
♦ Leasing commissions are paid to leasing firms on
  percentage basis on the initial term of the lease
  (approx. 5% to 6%)
♦ Lease renewals also require some commission
  payment (approx. 3%)
♦ Tenant Improvements (T.I.) are an allowance to take
  care of tenant needs when the market requires
♦ Leasing commissions and T.I. are a function of tenant
  turnover and market conditions
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               Summary of Proforma
                  Potential Gross Income
                  Less Vacancy
                  = Effective Gross Income
                  Less Operating Expenses
                  = Net Operating Income
                  Less Debt Service
                  = BTCF

             Then to Calculate Taxable Income

BTCF                                               Net Operating Income
Plus Principal Loan Repaid                         Less Mortgage Interest paid
Less Depreciation                      OR          Less Depreciation
Less amortization of points                        Less Amortization of points
Equals Taxable Income                              Equals Taxable Income
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                                                                                      7
             Proforma Summary (Contd.)


     Taxable Income Times the Tax Rate
     = Taxes Owed if Taxable Income is positive
     = Taxes Saved if Taxable Income is Negative

     BTCF Less Taxes Due OR Plus Taxes Saved
     = After Tax Cash Flow (ATCF)




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              Financial Feasibility Ratios
♦ Financial feasibility/performance of a real estate
  investment can be judged by financial ratios
♦ Leverage and Operating Ratios:
        Loan to Value Ratio (LTV)
        Debt Coverage Ratio (DCR)
        Breakeven Point
        Expense Ratio
♦ Single Period Profitability Measures:
        Cash on Cash
        After Tax Return on Equity
        Return on Asset (ROA); Value
♦ Multiple Period Return Measures:
        NPV
        IRR

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                                                                                       8
                            LTV Ratio
                       Mortgage Loan Balance
 Loan To Value Ratio = --------------------------------
                            Purchase Price
♦ Loan to Value ratio affects the financial risk of
  the investment
♦ Higher the LTV ratio means more risk to
  lender and greater the volatility of cash
  returns to equity for the property owner




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             Debt Coverage Ratio (DCR)
                                              Net Operating Income (NOI)
Debt Coverage Ratio = ----------------------------------
                                                              Debt Service

  ♦ The debt coverage ratio must exceed 1.0 in
    order for the property to make the mortgage
    payments and have something left over
  ♦ DCR can be used to calculate the
    supportable mortgage debt
  ♦ Supportable Mortgage with a given DCR:
        ♦ NOI / DCR / 12 / Monthly Mortgage Constant

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                                                                                     9
                    Breakeven Point

             Operating expenses + Mortgage payments
Breakeven Pt.= ------------------------------------------------------
                                  Gross Rent


 ♦ The breakeven point is the percentage of
   occupancy that a building must achieve in
   order to be able to pay all of its cash
   expenses and carry the financing
 ♦ The lower the breakeven point the better



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                      Expense Ratio

                         Operating expenses
     Expense Ratio = ---------------------------------------
                       Effective Gross Income)

 ♦ Expense ratio is used in comparison with
   similar property, but alone gives no information
 ♦ Too low an expense ratio might imply
   inadequate repairs and upkeeps
 ♦ Too high an expense ratio compared to peer
   properties may indicate that operating
   expenses are not being controlled properly
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                                                                                      10
                        Cash on Cash
                        Before Tax Cash Flow
        Cash on Cash = -------------------------------
                               Cash Equity*

             * Cash Equity = Purchase price
                            - Mortgage
                            + Points
  ♦ Cash on Cash, is a crude but useful indicator
    of “going in” profitability of a property
  ♦ Higher is better, however that generally
    property with high cash on cash ratio has
    lower appreciation expectations
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              After Tax Return on Equity

                           After Tax Cash Flow
After Tax Return on Equity = --------------------------
                                Cash Equity


♦ Similar to Cash on Cash, taking into effect the
  tax adjustment




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                                                                                       11
 Return on Asset (Going In Cap Rate)

                     Net Operating Income
Return on Asset = ---------------------------------------
                          Purchase Price


♦ The return on asset, also known as “cap rate”
♦ Used to determine ability of property to carry
  debt as well as a measure of overall
  profitability

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                                            Value

                        Net Operating Income
                 Value = -----------------------------
                                Cap Rate

 ♦ Here cap rate is the “market cap rate”
 ♦ Market cap rate reflects the returns required
   for similar property:
             Similar risk
             Similar growth prospects

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                                                                                         12
             Multiple Period Return Measures
                CF1 CF2                  Projected Resale CFT
Equity = PVe = ------ + -------- + ---- + -----------------------------
              (1+irr) (1 +irr)2              (1 + irr)T

 ♦ IRR: internal rate of return, solves the above equity
   where PVe is the present value of the equity based
   on all future sources of returns
 ♦ The Equity IRR is compared to the required rate of
   return and if the IRR is equal to or greater than the
   required rate of return on equity the investment is
   acceptable
      ♦ Typical IRRs are in the 12% to 15% range

 ♦ Projected resale cash flow is proceeds from
   reversion value minus selling costs and tax
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              Multiple Period Return (Contd.)
  ♦ Estimating the resale price or Reversion
    Value is typically done using the following
    formula,
                                 NOIT+1
             Resale Price T = -----------
                                   R
  ♦ Resale price value at time T based on the
    estimated NOI for the year following the sale
  ♦ R is the "going out" cap rate on the property
  ♦ R can be large, smaller or equal to Initial
    Year Cap Rate, depending on perception
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                                                                                       13
                        Lease Analysis and Cash Flow
                                 Projection
             ♦ Reliable cash flow projections require tenant
               by tenant lease analysis
             ♦ Evaluation of existing leases on basis of
               comparisons to the market rent for similar
               credit risk and size tenants
             ♦ To map over time:
                  Lease terms such as burden of expenses
                  passed on to tenant
                  Special features of allocation of unusual
                  expenses
                  Lease expirations and options for renewal
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                Example: Lease Analysis
Tenant                    Year 1         2           3            4           5           6            7              8   9       10
ABC Co. base rent          25,000 25,000 25,000 25,000 25,000

ABC Option to Renew                                                                     28,982 28,982 28,982 28,982 28,982
at change in CPI
estimated at 3%
Pass Through with a         4,600       4,900       5,000       5,000        5,000       6,600        7,000       7,400   7,800   8,200
$5000 cap for 5 years
XYZ Co. Base rent           6,000       6,180       6,365       6,556        6,753
Increasing at CPI no
pass throughs
XYC Replacement                                                                          6,500        6,500       6,500   6,500   6,500
Tenant with more
supply expected

Summary to be             35,600 36,080 36,365 36,556 36,753 35,582 35,982 36,382 36,782 37,182
collected



             12/13/2005                        Principles - Special Economy”: Norman G. Miller and David M. Geltner
                                   “Real EstateFIN4777 for the NewTopics in Real Estate - Professor Rui Yao                         28




                                                                                                                                          14
     The Impact of Cycles, marketing
     and Management on Cash Flows
♦ For management intensive properties, cash
  flows will be affected by the skill of the
  management and leasing team
♦ On the other hand an industrial warehouse
  filled with long term fixed rate triple net
  leases (where all expenses are passed
  through) can not be affected as much by
  management and creative property
  managers will do little to affect the rent
♦ A good tenant mix will enhance the drawing
  power and success of a mall
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             Management Impact (Contd.)




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